Opportunity Zones Offer Tax Deferrals to Real Estate Investors, But Benefits Should Be Weighed Against Like-Kind Exchanges
Real estate investors looking to shield their capital gains from tax are often curious about the Opportunity Zones that were created in the Bay Area following the adoption of the 2017 Tax Cut and Jobs Act to spur economic development in economically depressed areas. While these zones provide real estate investors with a wonderful opportunity to protect their capital gains from the sale of property from immediate tax, the deferrals they provide expire at the end of 2026. As a result, investors who are looking for long-term deferrals of their capital gains tax may be better served by like-kind exchanges (known as a “1031 Exchanges”).
Opportunity Zones are scattered throughout the Bay Area, but those which seem to be drawing the most interest from investors are those located in the West Oakland, Uptown, Jingletown (near Fruitvale), and Coliseum Industrial neighborhoods of Oakland. However, Opportunity Zones are not limited to the Bay Area and are located in economically distressed census tracts in all 50 states.
Both Options Offer Deferred Recognition of Gains
Investors may use either Opportunity Zones or 1031 Exchanges to defer the recognition of the gain on the sale of a real estate investment by reinvesting that gain into real property within 180 days of the sale. Both programs are also intended to encourage economic development by keeping investments in the real estate market. While 1031 exchanges are focused on commercial real estate and potentially other “like-kind” exchanges, Opportunity Zone tax benefits allow for any transfer of capital gains, whether it arises from a gain on section 1231 property (real estate) or other business and asset sale transactions.
Opportunity Funds Offer Three Avenues for Tax Relief
Generally, an investor can utilize the tax advantages of investing in a zone by investing in a Qualified Opportunity Fund, which is a partnership or corporation that has been set up to invest at least 90 percent of its holdings in an Opportunity Zone. The rules for Opportunity Funds are complex, but they essentially limit fund investments to new building construction and substantial improvements to existing buildings that are not currently being used. Additionally, because the funds are newly created entities, the IRS is still working out the rules governing Opportunity Funds.
Opportunity Funds provide real estate investors with three ways to reduce their capital gains tax on the gains from a property sale:
No recognized gain through 2026. Any taxable gain from the profits reinvested in an Opportunity Fund investment will not be recognized until December 31, 2026, or when the taxpayer’s interest in the fund is sold or exchanged, whichever happens first. That means a taxpayer cannot use an Opportunity Fund investment to shield the profits from a real estate sale indefinitely and must recognize the capital gains on those initial funds on either December 31, 2016, or the date the interest in the fund is sold.
Between 10% and 15% of deferred gains not taxed. Opportunity Fund investments benefit from a 10% step up in their tax basis after five years. Taxpayers who invest in a fund by December 31, 2019, may take advantage of an additional 5% step up after seven years (for a total of 15%).
Property appreciation not taxed after 10 years. Investors who remain in an Opportunity Fund for at least 10 years are not taxed on the gains resulting from the appreciation because the cost basis of a property will be treated as being equal to the fair market value of the property on the day it is sold or exchanged. However, a taxpayer must still recognize any gain on the gains that were initially reinvested in the fund on December 31, 2026.
1031 Exchanges Remain Popular with Investors
Historically, 1031 exchanges have been popular with real estate investors because they allow a taxpayer to reinvest the gain from the sale of property into a replacement property that is considered to be of a “like kind” to the property that was sold without recognizing any capital gain from the sale.
When the like-kind property is eventually sold the investor will be responsible for the capital gains tax on the difference between the basis in the original property and the sales price of the replacement property However, when a taxpayer sells the replacement property he or she retains the right to continue deferring recognition of the capital gain by reinvesting the gains from that sale in another like-kind property. These tax deferrals are distributed among partners and shareholders of an entity and realized in full when the final asset sale takes place or an individual investor leaves the entity.
Section 1031 also grants taxpayers some time in which to complete an exchange if a qualified intermediary is used. Those transactions are often referred to as three-party “Starker” exchanges where a middleman holds the proceeds from a real estate sale until the taxpayer uses the proceeds of the sale to purchase another investment property. The taxpayer then has 45 days from the sale of the initial property to notify the intermediary in writing of the property he or she intends to use as a replacement property. The taxpayer can designate up to three possible replacement properties, but he or she must eventually close on one of those properties. Finally, the taxpayer must close on the new investment property within 180 days of selling the old one.
Prior to the passage of the Tax Cuts and Jobs Act, some investors were allowed to exchange aircraft, equipment and franchise licenses under Section 1031, but the law amended the tax code so that only real estate qualifies as Section 1031 property.
Weighing the Benefits of Opportunity Funds vs. 1031 Exchanges
Perhaps the biggest advantage that 1031 Exchanges have over Opportunity Funds is that the exchanges allow for the profits from the sale of an investment property to be rolled over into another like-kind investment with no requirement that the gains must be recognized until the property is sold. If the profits from that sale were reinvested in an Opportunity Fund the taxpayer would be required to recognize the gain on the initial property sale on December 31, 2026. Additionally, the taxpayer would still need to recognize that gain, even when the Opportunity Fund investment loses money.
However, Opportunity Funds allow taxpayers to avoid the like-kind exchange requirements for a 1031 Exchange. That allows the gains from the sale of one type of property to be reinvested in another kind of property without recognizing any capital gains. A taxpayer may also find that the benefits of untaxed appreciation and the 10% to 15% step up outweigh the capital gains tax that will be due at the 2026 recognition event.
Weighing the relative merits of using an Opportunity Fund versus a 1031 Exchange involve the weighing of a number of complex factors and it is best to consult with an accounting professional to ensure that your choice results in the most tax savings possible. Additionally, because the IRS rules regarding Opportunity Funds are currently being finalized, an accountant will help ensure that your fund is complying with any changes in those rules.Tags: Laws, Opportunity Zones, Taxation
Categorised in: Real Estate
This post was written by Sean Allaband